Tax News: Check-The-Box Has ArrivedSpring 1997
The IRS has recently issued final regulations which allow virtually all unincorporated business entities to elect either corporation or partnership status for federal tax purposes. The regulations were effective January 1, 1997, and replace the existing entity classification system with a "check-the-box" system under which an "eligible entity" may elect its tax status.
Prior to the issuance of these regulations, classification was determined based on four corporate characteristics: continuity of life, centralized management, limited liability, and free transferability of interests. An entity with more than two of these characteristics was taxed as a corporation. The new check-the-box system permits considerably more flexibility in structuring partnership agreements and limited liability company operating agreements. While the four factors are now irrelevant for federal tax purposes, they remain important for other business reasons. For instance, family-held businesses may want to retain traditional restrictions on transferability in order to ensure continued family control.
Under the new regulations, certain business entities are automatically classified as corporations and, therefore, are unable to elect noncorpo-rate status. These entities include: state law corporations, insurance companies, state or federally chartered banks, certain entities organized under the laws of foreign countries, and special entities specifically given corporate status under the Internal Revenue Code, e.g. publicly traded partnerships.
Any business entity that is not required to be classified as a corporation is an "eligible entity" that is entitled to elect corporate or noncorporate status. A domestic eligible entity with at least two members is automatically classified as a partnership unless it elects to be classified as a corporation. A domestic eligible entity with only one member is disregarded as an entity separate from its owner and treated as a sole proprietorship if the owner is an individual, or as a branch or division if the owner is a corporation, unless the entity elects to be treated as a corporation. Thus, a one-member limited liability company formed under Wisconsin law and owned by an individual will be treated as a sole proprietorship for federal tax purposes, but will provide the individual with the advantage of limited liability for state law purposes.
A foreign eligible entity with two or more members will automatically be classified as a partnership if at least one member does not have limited liability, unless the entity elects to be classified as a corporation. If all the members have limited liability, the entity will be classified as a corporation unless it elects to be classified as a partnership. A foreign eligible entity with only one member that does not have limited liability will be disregarded as a separate entity unless it elects to be classified as a corporation.
An entity wishing to change its classification or that does not want its default classification must file Form 8832, Entity Classification Election, with the appropriate IRS Center. The election must specify the entity's name, address, taxpayer ID number, the chosen classification, and whether the entity is domestic or foreign. The effective date of the election specified on the form cannot be more than 75 days prior to the filing date and cannot be more than 12 months after the filing date.
A change in classification may, however, result in adverse tax consequences to the entity and its owners. If, for example, an entity changes from corporate status to that of a partnership, the change would be treated as a fully taxable corporate liquidation. Presumably, an entity changing from partnership status to that of a corporation would be afforded the flexibility under current law to choose its method of incorporation. An eligible entity that elects to change its classification may not change classification again within the 60 month period after the effective date of the election without IRS approval.
Although the new regulations are effective January 1, 1997, the IRS will not challenge the classification of an existing domestic eligible entity for periods prior to January 1, 1997, if the entity (i) had a reasonable basis for its claimed classification, (ii) recognized the federal tax consequences of any change in classification within the five years prior to January 1, 1997, and (iii) had not been notified in writing on or before May 8, 1996, that its classification was under examination by the IRS. Similar transition rules apply to foreign entities, including entities that are treated as "per se" corporations under the regulations.
Please contact a member of G&K's Tax and Employee Benefits Group if you have any questions regarding the effect of the new regulations.